Active Versus Passive Management: Which Is Better?

Clearly there is some type of vague cyclicality here. There seems to be a horizontal line at 45% around which the graph oscillates. At some points such as March 2005 to March 2006, and again in March 2009 to March 2010, a high percentage of managers outperform the S&P. On the other hand, these periods of strong outperformance are followed by sudden drops in performance. That is, the passive investor beat the active stock picker. I’m proposing the following behavioral reasons for the cyclicality:

Picture many highly skilled analysts all competing to obtain and synthesize relevant information on a stock before everyone else. So many are working so hard, that it is difficult to uncover valuable information before others. At the extreme point, where all information is known by all hard-working analysts, there is virtually no advantage to staying in the game if you’re hoping to gain an information edge. Ironically, staying--and expecting not to gain an information edge--would ensure that no one else gains the information either.

If all keep working as hard as possible and none drop out, active management has no edge. With no information edge, indexing begins to look like an appealing alternative and may very well be outperforming active management. But what if some participants become discouraged from the lack of return on their efforts, and they drop out of the active circle and choose to index? That creates the opportunity for the other active die-hards that haven’t given up.

I propose that this dynamic is behind the cyclical shifts of active versus passive performance: When market participants become frustrated by the lack of outperformance of active management, some exit the active arena, choosing instead to index. That very exit from the active arena sets the stage for the remaining active managers to outperform. The siren song of active outperformance then lures those participants back in the game. But when everyone piles into active management, the ability to gain an information advantage diminishes, causing the cycle of switching back to passive again. And thus the cycle continues. In an odd way, one could argue that the oscillations between active and passive promotes a type of market stability.

Examine the graph again, this time keeping my theory in mind. I’m sure you will see the pattern makes more sense. When considering the choice of active versus passive, a more reasonable answer is to open your mind to both alternatives, not just one.